Alphabet’s Google ‘TAC’ Could Be Hurt By Regulations, Says RBC

By

Tiernan Ray

Sept. 11, 2017 11:16 a.m. ET

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RBC Capital Markets’s Mark Mahaney today reiterates an Outperform rating on shares of Alphabet (GOOGL), while warning that "the market may be under- appreciating the regulatory risk facing Google,” which could impact the company’s earnings and its stock multiple, which he notes is relatively high, historically.

Mahaney follows up on a piece he wrote in mid-August, when warned of a rising climate of anti-trust activity around the world as pertains to Google and Facebook (FB) and Amazon (AMZN).

After conversations with investors and lawyers, Mahaney today writes that “Google is in the cross-hairs” of regulators and that it has “the greatest regulatory risk among large cap ’Nets."

In fact, Mahaney thinks investors may not realize that regulatory action, especially by the European Union, is connected to the biggest investor concern, rising “traffic acquisition cost,” or TAC.

"Rising TAC at GOOGL has been one of the biggest concerns we have heard from investors,” writes Mahaney.

"The rub here is that the next potential next EU regulatory action against Google may well involve forcing Google to ‘unbundle' Android from its other services – Search, YouTube, Maps, etc."

"This in turn could provide more negotiating leverage to OEMs...and thus lead to potentially higher TAC expenses."

Mahaney briefly reviews the most recent regulatory developments:

These past few weeks have seen Google at least twice in the news regarding regulatory matters. Heading into Labor Day Weekend, Google filed its proposed remedies to the European Commission’s anti-trust charge related to its Comparison Shopping segment. Although the European Commissioner of Competition, Ms. Margrethe Vestager, told CNBC at a conference over Labor Day Weekend that her office was satisfied with the initial review of Google’s compliance proposal, calling it a step “in the right direction,” the EC still is not done with its in-depth review of the filing. If Google does not successfully comply with the EC’s ruling by the end of September, it could face daily fines of up to 5% of its daily revenue. Moreover the European Commission has already initiated two other Statement of Objections against Alphabet for anti-competitive practices related to Android and AdSense. The Android case was brought to our attention last week from an article published in the UK’s Sunday Times on September 3rd: “Google to be hit with record EU fine over claims of phone software abuse.” This was the 2nd appearance in the news.

While noting this is “all hypothetical,” he notes any action to effectively “unbundle” Android from the rest of Google’s operations could drive up the $21 billion in TAC Google has to pay out annually:

The outcome of the EU Android investigation is unknown and leverage could play out several ways (heck, maybe Google would start charging for Android...). But TAC is a major expense -- $21B in ’17...22% of Google’s Ad Revenue. It has been a major investor concern. And every 100 bps of increased Total TAC would clip $0.41 or 1% from our ’18 EPS estimate. 1% wouldn’t change an investment thesis. But 5% or $2.06 could.

The true risk for the stock is simply that the stock multiple is “elevated”:

The numbers take-away from above is that the greater risk to GOOGL may actually come from Multiple vs. EPS pressure. And here we’d point out that GOOGL is now trading in the upper half of its recent (5 year) EV/EBITDA valuation range. The stock-picking concern would be that the Android TAC link could put pressure on GOOGL’s multiple, either limiting any meaningful appreciation from current levels or bringing it back in-line with its historic average.

Facebook shares drop almost 7% on Friday's disclosure of mishandling of user data by the consulting firm Cambridge Analytica, KLA-Tencor buys fellow chip equipment maker Orbotech, Deutsche Bank analysts are bullish on fiber optics name II-VI but negative on Arista Networks, GrubHub stock is getting pricey according to Stifel analyst John Egbert, Fitbit finds a new believer in Craig-Hallum's Alex Fuhrman, ex-chairman Paul Jacobs of Qualcomm is hoping analysts will vote in sympathy with him at the company's shareholder meeting on Friday, Dell topped server sales in Q4 and bumped aside Hewlett Packard Enterprise, Google's Diane Greene is mulling a big acquisition to boost the company's cloud services, Apple is moving forward with its own display technology called "micro LED," and Oracle is set to report results after the closing bell.

"While it's background noise for investors in the near-term, with the News Feed overhaul and other actions that Facebook has implemented over the past few months, its clear with more 'heat in
the kitchen from the Beltway' that further modest changes to their business model around advertising and news feeds/content could be in store over the next 12 to 18 months," analyst Daniel Ives wrote.

Alphabet’s Google ‘TAC’ Could Be Hurt By Regulations, Says RBC

RBC Capital Markets’s Mark Mahaney today reiterates an Outperform rating on shares of Alphabet (GOOGL), while warning that &quot;the market may be under- appreciating the regulatory risk facing Google,” which could impact the company’s earnings and its stock multiple, which he notes is relatively high, historically.

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